Long-term Factors Driving the Foreign Exchange Market: Trade Flows

Long-term factors driving the Foreign Exchange Market: Trade Flows

This lesson will cover the following

  • General thoughts on Forex drivers
  • Trade flows

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Capital and Trade Flows

Trade Flows

Flow of trade is the core of all international transactions. Trade flows reflect the net trade balance of a given country. Countries with the status of net exporters are those, which export more to international clients than they import from producers abroad. They usually have a net trade surplus. It is more likely that currencies of these countries will increase in value, as their currencies are being purchased more than they are sold. International customers, who have interest in purchasing the exported good or service will first buy the currency of the exporting country, therefore, demand for that currency will be boosted.

Countries with the status of net importers are those, which export less to international clients than they import from international producers. They usually have a net trade deficit. It is more likely that currencies of these countries will lose value, because these currencies are being sold more than they are purchased. Import companies will first have to sell their local currency and buy the currency of the producer of the good or the service, therefore, demand for the currency of the importing country will decrease.

pencilLet us have an example. Japanese economy is developing well and domestic stocks are surging. At the same time, United States’ economy is not providing enough opportunities for investments. In this situation residents in the US will be selling the local currency and purchasing Japanese yens in their desire to take advantage of the booming Japanese economy. The result will be a capital outflow from the United States and a capital inflow for Japan. In foreign exchange market terms, this situation will lead to the devaluation of the US dollar and the appreciation of the Japanese yen, because demand for the dollar diminishes and demand for the yen increases. Or, USD/JPY will fall in value.

Conclusion

Any transaction, occurring internationally, produces two offsetting entries – capital flow balance (capital account) and trade flow balance (current account). These two entries comprise the balance of payments of a given country. Theoretically, these entries should balance and add up to zero in order to maintain the status quo in a country’s economy and currency rates. Countries may have positive or negative trade balances and positive or negative capital flow balances. If a country is to minimize the net effect caused by both on its currency exchange rates, it needs to find a balance between them.

pencilLet us provide another example. The United States has experienced a considerable trade deficit in recent years, as imports exceeded exports. US trade balance is negative and the country purchases more from foreign companies than it sells to, thus, it needs to fund this deficit. The negative flow of trade may be neutralized by a positive flow of capital, because foreign investors make either real, or portfolio investments. The country will usually try to minimize the deficit on its trade balance and maximize its capital inflows until the two balance out. The net result of the difference between trade flows and capital flows will usually influence the direction, which country’s currency will take. If US overall trade and capital balance tend to show negative results, the national currency will likely be devalued. If the overall balance tends to be positive, this will likely have a positive effect on the dollar.

Any change in country’s balance of payments causes a direct impact on the exchange rates of its currency. Therefore, every investor can pay close attention to economic reports, related to the balance of payments and make his/her own interpretation of the outcome, which will occur. A possible increase in a given country’s trade deficit, accompanied by a possible decrease in the capital flow will lead to a deficit on the balance of payments, therefore, an investor should expect a devaluation of the national currency.

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